Lecture 1: Course Overview and Review of Institutions and Markets
The goals of this class
- Understand important financial institutions and markets
- Provide a toolkit for creating portfolios of financial assets
- Use asset pricing models to understand the trade-off between risk and return
- Apply these models to:
- identify investment opportunities
- evaluate portfolio performance
Who am I?
- Former research economist at the Federal Reserve Bank of New York (2015-2018)
- PhD in economics at Harvard from 2009-2015
- Research associate at the FRBNY (2007-2009)
- Main research focus:
- Consumer finance – bankruptcy, mortgages, housing
- Applied statistics – machine learning and other methods
- Email: paul.goldsmith-pinkham@yale.edu
- Please reach out if you have any concerns or questions re: policy that are not laid out in the syllabus.
- Website: http://paulgp.github.io
- Office: 4532
Timeline for our course
Part 1: Institutional details
- Who are the buyers and issuers of financial instruments?
- Define assets + securities classes
- How are financial assets traded?
- How have these financial assets performed historically?
- Strong focus on statistical properties and data
Timeline for our course
- How do we interpret observed returns?
- Build to a model of returns
- Three ingredients necessary for our models:
- Defining risk appetite/aversion
- Understanding mean‐variance trade-off
- Allocating between risky and safe investments
- Use models to construct a portfolio of risky investments
- Captial Asset Pricing Model
- Arbitrage Pricing Theory / Factor Models
Timeline for our course
- How consistent is CAPM with the data?
- How consistent is the data with APT?
- Markets are efficient? Or is it behavioral?
- How should we use the models when there are market anomalies?
- Active portfolio management
- Treynor-Black / Black-Litterman
- Robust Portfolio Management
Timeline for our course
Part 4: Evaluate and attribute portfolio returns
- CAPM / APT describe returns from a passive strategy (no skill required)
- How should we evaluate active managers?
- Portfolio evaluation techniques answers:
“Did you beat your benchmark?”
- Performance attribution answers the question,
“How did you beat your benchmark?”
Timeline for our course
- Private equity and hedge funds
- International investing
- Fixed income (bonds, futures, forwards)
Class requirements
- Straight from the syllabus!
- Three problem sets as homework:
- Due February 16, March 2 and May 4
- To be done individually
- Two case write-ups:
- Yale University Investments Office (Due in class April 4)
- Firefighter (Due in class April 18)
- To be done in groups 3-5
- One midterm and one final:
- March 5 in class
- May 7 in class
Section 1 TA: Nikhil Maddirala
Section 2 TA: Akshay Rao
Institutions
Global assets under management
Institutions
U.S. Institutional Holdings

Institutions
Mutual Funds
- Also known as open-end funds
- Investors pool and benefits from sharing information
collection and back‐office costs
- Fund issues new shares when investors buy in and redeems shares when investors cash out
- Priced at Net Asset Value (NAV):
\[ \frac{\text{Market Value of Assets} - \text{Liabilities}}{\text{Shares Outstanding}} \]
Institutions
Mutual Funds Fees
- Fee Structure: Four types
- Operating expenses (recurring)
- 12 b‐1 charge (recurring)
- Front‐end load (one time)
- Back‐end load (one time)
- Fees must be disclosed in the prospectus
- Share classes with different fee combinations
Institutions
Example of Fees for Various Classes of Mutual Funds
- Compare the A, B and C shares
- What are the trade-offs between initial and deferred loads?
- Level of annual fees and expenses
Mutual Funds - Fees and Incentives
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Mutual Funds - Fees and Incentives
Fund flow response distorts risk-taking incentives (Chevalier and Ellison (1997))
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Mutual Funds - Costs over time
Mutual fund expense ratios have fallen over time, driven by several factors
- Scale economies - assets under management have grown
- Competition - investors pick funds with lower expense ratios
- Increased presence of employer-sponsored retirement plans

Do mutual fund managers earn their fees?
- How could we answer this?
- One idea: how do mutual funds do compared to an index?
- Performance of actively managed funds below the return on:
- the Wilshire index in 23 of the 39 years from 1971 to 2009
- the S&P index in 30 of the 47 years from 1970 to 2017

Institutions
Mutual Funds - Do fund managers earn their fees?
- Are all mutual fund managers like Andy Dwyer, or just the average?
- Malkiel (1995) evaluates 239 mutual funds with at least ten-year records
- Compare each fund’s performance to holding the S&P 500
Institutions
Mutual Funds – is there a “hot hand”?
- Evidence for persistent performance is weak, but suggestive
- Malkiel (1995) tracks funds based on above/below median performance:

Institutions
- Bollen and Busse (2004) find tiny persistence at the quarterly level

Institutions
Mutual Funds – luck or skill?
Fama French “Luck vs Skill in Mutual Fund Returns” 2010
- Value weighted portfolio of active funds earns the market return, minus fees
- Distribution of “alpha” looks more consistent with luck than skill
Net Returns

Gross Returns

Institutions
Closed End Funds
- Unlike mutual funds (open-end), no change in shares outstanding
- Old investors cash out by selling to new investors
- Managers unburdened with managing flows
- Traded continuously on exchanges
- Priced at premium or discount to NAV
- No easy arbitrage to close price gaps
- Hedge funds may ride discounts
- Alternatively, may attempt to “open” funds
Institutions
What else? Other buyers/Other perspectives
- Pension funds
- Endowment Funds
- Alternative Asset Managers
- to be discussed in the context of cases and guest lectures
- Next up…market structure
Market Structure
What kinds of markets are there?
- Specialist Markets
- Over-the-counter (OTC) markets
- Electronic Communication Markets
Market Structure
What types of orders are there?
- Market order – Buy or sell order to be executed immediately at prevailing bid/ask price
- Limit order – Buy or sell order with a pre‐specified limit for the price
Limit orders make up a limit order book
Limit orders make up a limit order book
Market Structure
Types of Markets: Specialist Exchanges
- Example of a specialist exchange: NYSE
- Trading traditionally occurred through a combination of an auction (the order book) and a market maker (the specialist)
- Orders sent to exchange may be cleared electronically or sent to specialist
- Only one specialist for each stock
- Specialist may act as broker or as a dealer
Market Structure
Roles of Specialists in Specialist Exchanges
- Broker
- Matches buy and sell orders
- Income generated by commissions
- Dealer
- Specialists maintain their own bid and ask quotes and fill orders with own account if market spread too high
- Historically, participated in about 25% of all transactions
- Maintained price continuity
Market Structure
Types of Markets: OTC Markets
- Trades negotiated dealer‐to‐dealer
- Nasdaq (National Association of Securities Dealers Automated Quotation system)
- Originally, a price quotation system
- Large orders may still be negotiated through brokers and dealers
- Today, NASDAQ provides electronic trading (less OTC)
Market Structure
Types of Markets: Electronic Communication Networks
- Private computer networks that directly link buyers with sellers for automated order execution
- To attract liquidity, networks may pay rebates to liquidity providers (market makers)
- Electronic clearing facilitates high frequency trading
Market Structure
Electronic Communication Networks and High Frequency Trading
- Risks of high speed algorithmic trading include market disruption
- Flash Crash (2010)
- On May 6, 2010, US indices fell by more than 5% in a matter of minutes, before rebounding almost as quickly
- Knight Capital (2012)
- Flawed deployment of new trading program bankrupts major market maker
- Lost 440 million dollars from one programming mistake
Market Structure
Electronic Communication Networks and flash crashes
SEC findings suggest the decline was triggered by a large automated sell order for S&P futures by a mutual fund
- Existing low volume due to high market uncertainty
- Sell order (75K contracts) was an automated algorithm that directed to sell 9% of prior minute’s trading volume
- HFTs responded to high volume of trades, but could not find fundamental buyers (SEC describes a game of “hot‐ potato”)
- High volume led to acceleration in sell order speed, which drove higher volatility and volume
Market Structure
Short-selling
- In our optimal portfolio, we’ll have the option to “short”–sell stocks that we don’t own
- Why would we?
- Stock may be overpriced (negative alpha)
- Stock may be appropriately priced, but we want to hedge out risk from a long position in a similar security (pairs trading)
- So what is it?
Short-selling: you have to fight the witch
(Not really)
Market Structure
Short-selling Mechanics
Suppose we have one dollar and believe stock A will underperform stock B.
- Buy $1 of stock B
- Borrow $1 worth of stock A ( \(1 \big/ P_A\) shares) and promptly sell the stock
- Now, you owe the owner of A his shares back and will have to repurchase them in the market at tomorrow’s price
- Proceeds from the sale serve as collateral to stock lender (e.g. $1)
- Reg T requires 50% additional collateral (above and beyond proceeds) be kept in account (shares of B will suffice)
\[\text{Final Payoff} = 1 + (r_B ‐ r_A) + \ldots+ \underbrace{\text{short rebate}}_{\text{to be defined}}\]
What happens if stock goes down 10x? up 10x?
Market Structure
What is the short rebate?
- Short rebate is the interest I earn on my dollar of collateral sitting with the stock lender
\[ \text{Short Rebate} = r_{f} - \text{Security lending Fee} \]
- Securities lending fees vary greatly and reflect how easy the shares are to borrow (often less than 20 bps)
- In obvious shorting situations, short rebate will go negative (shares “hot or trading “special”) or can’t be found
Market Structure
Alternative ways to short stocks: synthetic shorts
Consider the following replicating strategy:
- Buy a put and sell a call at the current strike price
- Have the option to sell stock at current price
- Give someone else the option to buy the stock at today’s price
- What happens if real stock goes down 10x? up 10x?
- However, options traded on less than half of publicly traded firms
- Moreover, options market behaves badly for “hot shares”
- Put-call parity is violated by large amounts of short interest – E.g. 3com and Palm
Market Structure
Can the Market Add and Subtract? 3com/Palm Example
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